Question

The required rate of return in valuing an asset is based on the risk involved. Identify two types of risk that affect investments and briefly describe them.

Answer 1

Solution:

The required rate of return are directly related by the simple fact that as risk increases, the required rate of return increases. When risk decreases, the required rate of return decreases. The required rate of return reflects the amount of risk associated with investments.

Two types of risk that affect investments Interest-rate risk and Inflation Risk.

1. Interest-rate risk: Price fluctuations and permanent loss of principal may make some investors feel inclined to retreat to the safety of low-risk investments like savings accounts or U.S. government bonds. However, while an investor can protect themselves from losses with guaranteed investments, it cannot protect them from earning sub-par returns if interest rates drop.

   For example, a five-year U.S. Treasury security may seem about as safe an investment as you could choose. Price volatility is fairly limited and the principal is guaranteed upon maturity. However, their interest rates are subject to change over time and that can greatly affect your rate of return.

2. Inflation Risk: Inflation risk is the risk that your purchasing power will be reduced if the value of your investments does not keep up with inflation. Inflation is a sustained rise in overall price levels. Inflation risk is particularly relevant if you own cash or debt investments like bonds. However, Shares offer some protection against inflation because most companies can increase the prices that they charge to their customers.Inflation means higher consumer prices. This often slows sales and reduces profits. Higher prices will also often lead to higher interest rates. For example, A Bank may raise interest rates to slow down inflation. These changes tend to bring down stock prices. Commodities however, may do better with inflation, so their prices may rise.